Suppose it costs the parts supplier $100 to make the parts. To this he adds 10 percent for profit. He then charges the motor manufacturer $110 for the parts.
The motor manufacturer who bought the parts then builds the motor. He adds a 10 percent profit to his manufacturing costs; he also adds a 10 percent profit to the cost of the parts he bought. So, in his total price to the pump manufacturer he includes $121 for the parts—the $110 he paid the parts supplier plus $11 profit.
The pump manufacturer manufactures the pump. He adds a 10 percent profit to his cost of manufacturing the pump; he also adds a 10 percent profit to the cost he paid for the motor. In his total price, the pump manufacturer charges the shipbuilder $133 for the parts used in the pump motor…
The shipbuilder buys the completed motor-driven pump and installs it in the ship. He charges the Government 10 percent profit on his installation costs; in addition, he charges a 10 percent profit on the cost he paid for the motor-driven pump. Thus, in his price to the Government, the shipbuilder charges $146 for the parts used in the pump motor…
Of the $46 in total profit, only $13 would be visible to the Government as “profit”—the remaining $33 would be included in the shipbuilder’s “costs.”
That was Adm. Hyman Rickover in the 1968 “Economics of Military Procurement” hearing. We sometimes call this “recursive” profits.
Of course everyone knows this happens. Most certainly, when the “roundaboutness” of production increases, the layering of profit occurs — even in the commercial world. All firms in the supply chain aim for accounting profits (equating to zero economic profit, just enough profit to stop divestiture from the industry).
However, in the commercial world, firms that are not vertically integrated like retail will accept relatively low accounting profits. For example, 2 percent profit-on-sales is tremendous if the company’s value-add is only 4 percent (i.e., 50 percent return on investment). For integrated suppliers, that same 2 percent-on-sales might not be worth it.
DoD’s weighted profit guidelines make provisions for value-add, but I think they still incentivize more outsourcing than may be efficient. I’ve empirically found from defense contractor cost reports that the proportion of work going to materials or subcontractors has dramatically increased since the 1970s (at least in aerospace) from perhaps 40 percent outsourced to 70-80 percent outsourced. At the same time, reported profit-on-sales remained pretty much the same, as though that was what government negotiated to. Wish I could share it, but that’s back on government computers.
Paying profit-on-profit isn’t so much a problem. Increasing the number of links in the supply chain may lower overall costs as an instance of specialization and trade. However, zero “economic” profits may equate to different accounting profits depending on the business model. The level is usually governed by competitive forces. The fear I think Rickover expressed was that government pricing policies rewarded unproductive outsourcing to achieve high business returns.
ECONOMICS OF MILITARY PROCUREMENT, HEARINGS BEFORE THE SUBCOMMITTEE ON ECONOMY IN GOVERNMENT OF TR JOINT ECONOMIC COMMITTEE CONGRESS OF THE UNITED STATES NINETIETH CONGRESS, SECOND SESSION, NOVEMBER 11,-12, 13, AND 14, 19, PART -2 [Thursday, November 14, 1968] Testimony of Vice Admiral IL G. Rickover. U.S. Navy
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